Fiscal Policy: The Keynesian View and Historical Perspective

1. Fiscal Policy: The Keynesian View and Historical Perspective 3 11 3 11

2. The Great Depression and Macroeconomics • The Great Depression exerted a huge impact on macroeconomics. • The national income accounts that we use to measure GDP were developed during this era. • Several of the basic concepts of macroeconomics and much of the terminology were initially introduced during the 1930s. • Keynesian economics was also an outgrowth of the Great Depression.

3. Keynesian Economics: A Historical Overview • John Maynard Keynes was probably the most influential economist of the 20th Century. • Keynes developed a theory that provided both an explanation for the prolonged unemployment of the 1930s and a recipe for how to generate a recovery. • Keynesian analysis indicated that fiscal policy could be used to maintain a high level of output and employment.

4. Keynesian Economics: A Historical Overview • The Keynesian view dominated macroeconomics for 3 decades following WWII. • Keynesian economics began to wane during the 1970s because it was unable to explain the simultaneous occurrence of high unemployment and inflation. • But, the severe recession of 2008-2009 generated renewed interest in Keynesian analysis.

5. Game Plan for Analysis of Fiscal Policy • This chapter will present the Keynesian view of fiscal policy and consider how it has evolved through time. • The next chapter will focus on alternative theories and consider incentive effects that are largely ignored within the Keynesian framework. • Taken together, these two chapters provide a balanced presentation of current views on the potential and limitations of fiscal policy as a stabilization tool.

6. The Great Depression and the Macroadjustment Process

7. The Great Depression and the Macroadjustment Process • Prior to the Great Depression, most economists thought market adjustments would direct an economy back to full employment rather quickly. • The length and severity of the Great Depression changed these views.

8. The Great Depression and the Macroadjustment Process • The depth and length of the economic decline during the 1930s is difficult to comprehend • Between 1929 and 1933, real GDP fell by more than 30%. • In 1933, nearly 25% of the U.S. labor force was unemployed. • The depressed conditions were prolonged. In 1939, a decade after the plunge began, the rate of unemployment was still 17% and per-capita income was virtually the same as a decade earlier.

9. The Great Depression and Keynesian Economics • Keynes provided an explanation for the prolonged depressed conditions of the 1930s. • He argued that spending motivated firms to produce output. • If spending fell because of pessimism and other factors, firms would reduce production. • When an economy is in recession, Keynesians do not believe that reductions in either resource prices or interest rates will promote recovery. • As a result, market economies are likely to experience recessions that are both severe and lengthy.

10. The Keynesian Concept of Equilibrium • In the Keynesian model, firms will produce the amount of goods and services they believe people plan to buy. • Equilibrium occurs when total spending equals current output. When this is the case, producers have no reason to expand or contract output. • If total spending (demand) is deficient, depressed conditions and high levels of unemployment will persist. • This is precisely what Keynes believed happened during the 1930s.

11. The Keynesian Concept of Equilibrium • If total spending is less than full employment output, inventories will rise and firms will reduce output and employment. • The lower level of output and employment will persist as long as total spending is less than output. • Total spending (AD) is key to the Keynesian macroeconomic model. • Keynes believed that the cause of the Great Depression was weak AD – deficient total spending on goods and services.

12. The Multiplier Principle • The concept that an independent change in expenditures (such as investment) leads to an even larger change in aggregate output. • The multiplier concept builds on the point that one individual’s spending becomes the income of another. • Income recipients will spend a portion of their additional earnings on consumption. In turn, their consumption expenditures will generate additional income for others who also spend a portion of it. • Thus, growth in spending can expand output by a multiple of the original increase.

13. 3/4 3/4 3/4 3/4 3/4 3/4 3/4 The Multiplier Principle (Exhibit 1) Expenditure stage Additional income(dollars) Additional consumption(dollars) Marginal propensity to consume Round 1 1,000,000 750,000 562,500 Round 2 750,000 Round 3 562,500 421,875 421,875 316,406 Round 4 316,406 237,305 Round 5 949,219 711,914 All others Total 4,000,000 3,000,000 For simplicity (here) it is assumed that all additions to income are either spent domestically or saved. • The multiplier concept is fundamentally based upon the proportion of additional income that households choose to spend on consumption: the marginal propensity to consume (here assumed to be 75% = 3/4). • Here, a $1,000,000 injection is spent, received as payment, saved and spent, received as payment, saved and spent … etc. … until … effectively, $4 million is spent in the economy.

14. 1 M= 1 - MPC The Multiplier Principle • The term multiplier is also used to indicate the number by which the initial change in spending is multiplied to obtain the total increase in output. • In the previous example, a $1 million initial increase in spending expanded output by a total of $4 million. Thus the multiplier was 4. • The size of the multiplier increases with the marginal propensity to consume (MPC). • Specifically the relationship between the MPC and the multiplier follows this equation:

15. The Multiplier and Economic Instability • The multiplier concept also works in reverse – reductions in spending will also be magnified and generate even larger reductions in income. • Even a minor disturbance may be amplified into a major disruption because of the multiplier. • Keynesians argue that the multiplier concept indicates that market economies have a tendency to fluctuate back and forth between excessive demand that generates an economic boom and deficient demand that leads to recession.

16. Adding Realism to the Multiplier • In evaluating the importance of the multiplier, one should remember: • An increase in government spending will require either higher taxes or additional government borrowing. • This will often generate secondary effects, reducing spending in other areas. • It takes time for the multiplier to work. • The multiplier effect implies that the additional spending brings idle resources into production without price changes -- this is unlikely to be the case during normal times. • During normal times, the demand stimulus effect of additional spending is substantially weaker than the multiplier suggests.

17. Keynes and Economic Instability:A Summary • According to the Keynesian view, fluctuations in total spending (AD) are the major source of economic instability. • Keynesians believe that market economies have a tendency to fluctuate between economic booms driven by excessive demand and recessions resulting from insufficient demand. • The multiplier concept magnifies these fluctuations.

18. The Keynesian View of Fiscal Policy

19. Budget Deficits and Surpluses • Budget deficit: present when total government spending exceeds total revenue from all sources • When the money supply is constant, deficits must be covered with borrowing. The U.S. Treasury borrows by issuing bonds. • Budget surplus: present when total government spending is greater than total revenue • Surpluses reduce the magnitude of the government’s outstanding debt.

20. Budget Deficits and Surpluses • Changes in the size of the federal deficit or surplus are often used to gauge whether fiscal policy is stimulating or restraining demand. • Changes in the size of the budget deficit or surplus may arise from either: • a change in cyclical economic conditions • a change in discretionary fiscal policy • The federal budget is the primary tool of fiscal policy. • Discretionary changes in fiscal policy: deliberate changes in government spending and/or taxes designed to affect the size of the budget deficit or surplus.

21. Fiscal Policy and the Good News of Keynesian Economics • Keynesian theory highlights the potential of fiscal policy as a tool capable of reducing fluctuations in AD. • Prior to the Great Depression, it was widely believed that the government should balance its budget. Keynesians challenged this view. • Rather than balancing the budget annually, Keynesians argue that counter-cyclical policy should be used to offset fluctuations in AD. • This implies that the government should plan budget deficits when the economy is weak and budget surpluseswhen strong demand threatens to cause inflation.

22. Keynesian Policy to Combat Recession • When an economy is operating below its potential output, the Keynesian model suggests that fiscal policy should be more expansionary. • increase in government purchases of goods & services • or reduction in taxes

23. SRAS2 Keynesians believe that allowing the market to self-adjust may be a lengthy and painful process. E2 Expansionary fiscal policy stimulates demand and directs the economy to full-employment. E3 AD2 Expansionary Fiscal Policy LRAS SRAS1 PriceLevel P2 P1 e1 P3 AD1 Goods & Services(real GDP) Y1 YF • At e1 (Y1),the economy is below its potential capacity YF . There are 2 routes to long-run full-employment equilibrium: • Rely on lower resource prices to reduce costs and increase supply to SRAS2, restoring equilibrium at YF (E3). • Alternatively, expansionary fiscal policy could stimulate AD (shift to AD2) and direct the economy back to YF (E2).

24. Keynesian Policy To Combat Inflation • When inflation is a potential problem, Keynesian analysis suggests fiscal policy should be more restrictive. • reduction in government spending • or increase in taxes

25. SRAS2 E3 Restrictive fiscal policyrestrains demand and helps control inflation. E2 AD2 Restrictive Fiscal Policy PriceLevel LRAS SRAS1 P3 P1 e1 P2 AD1 Goods & Services(real GDP) Y1 YF • Strong demand such as AD1 will temporarily lead to an output rate beyond the economy’s long-run potential YF. • If maintained, the strong demand will lead to the long-run equilibrium E3 at a higher price level (SRAS shifts to SRAS2). • Restrictive fiscal policy could reduce demand to AD2 (or keep AD from shifting to AD1initially) and lead to equilibrium E2.

26. Keynesian View of Fiscal Policy:A Summary • The federal budget is the primary tool of fiscal policy. • Keynesians stress the importance of counter-cyclical policy. • The budget should shift toward deficit when the economy is threatened by recession. • The budget should shift toward surplus when inflation is a threat.

27. Questions for Thought: 1. What is the multiplier principle? Does the multiplier principle make it more or less difficult to stabilize the economy? Explain. 2. Why did John Maynard Keynes think the high level of unemployment persisted during the Great Depression? What did he think needed to be done to avoid the destructive impact of circumstances like those of the 1930s?

28. Fiscal Policy Changes and Problems of Timing

29. Problems with Proper Timing • There are three major reasonswhy it isdifficult to time fiscal policy changesin a manner that promotes stability: • It takes time to institute a legislative change. • There is a time lag between when a change is instituted & when it exerts significant impact. • These time lags imply that sound policy requires knowledge of economic conditions 9 to 18 months in the future. But, our ability to forecast future conditions is limited. • Discretionary fiscal policy is like a two-edged sword; it can both harm and help. • If timed correctly, it may reduce economic instability. • If timed incorrectly, however, it may increase economic instability.

30. Automatic Stabilizers • Automatic Stabilizers: Without any new legislative action, these tools will increase the budget deficit (reduce the surplus) during a recession and increase the surplus (reduce the deficit) during an economic boom. • The major advantage of automatic stabilizers is that they institute counter-cyclical fiscal policy without the delays associated with legislative action. • Examples of automatic stabilizers: • unemployment compensation • corporate profit tax • progressive income tax

31. Questions for Thought: 1. Why is the proper timing of changes in fiscal policy so important? Why is it difficult to achieve? 2. Automatic stabilizers are government programs that tend to:a. bring expenditures and revenues automatically into balance without legislative action.b. shift the budget toward a deficit when the economy slows but shift it towards a surplus during an expansion.c. increase tax collections automatically during a recession.

32. The Keynesian Aggregate Expenditure Model

33. The Keynesian Aggregate Expenditure (AE) Model • All models make simplifying assumptions. • Within the framework of the Aggregate Expenditure model: • There is a specific full-employment level of output. • Wages and prices are completely inflexible until full-employment is reached. • Once full employment is reached, increases in demand lead only to higher prices.

34. Plannedgovernmentexpenditures Aggregate expenditures Plannedconsumption Plannedinvestment = + + + The Keynesian Aggregate Expenditure (AE) Model • In the Keynesian AE model: • As income expands, consumption increases, but by a lesser amount than the increase in income. • Both planned investment and government expenditures are independent of income. • Planned net exports decline as income increases. Plannednetexports

35. Saving C Dissaving Aggregate Consumption Function Planned consumption(trillions of $) 45º line 13 10 7 4 45º Real disposable income(trillions of dollars) 4 7 10 13 • The Keynesian model assumes that there is a positive relationship between consumption and income. • However, as income increases, consumption increases by a smaller amount. Thus, the slope of the consumption function (line C) is less than 1 (less than the slope of the 45° line).

36. $1.2 1.2 1.2 1.2 1.2 Income and Net Exports Total output(real GDP in trillions) Planned exports(trillions) Planned imports(trillions) Planned net exports (trillions) $13.4 $1.00 $0.20 13.7 1.05 0.15 14.0 1.10 0.10 14.3 1.15 0.05 14.6 1.20 0.00 • Because exports are determined by income abroad, they are constant at $1.2 trillion. • Imports increase as domestic income expands. • Thus, planned net exports fall as domestic income increases.

37. Planned aggregateexpenditures Currentoutput = Keynesian Equilibrium • According to the Keynesian viewpoint, equilibrium occurs when: • When this is the case: • Businesses are able to sell the total amount of goods & services that they produce. • There are no unexpected changes in inventories. • Producers have no reason to either expand or contract their output during the next period.

38. Total aggregateexpenditures Currentoutput < Total aggregateexpenditures Currentoutput > Keynesian Equilibrium • When firms accumulate unplanned additions to inventories that will cause them to cut back on future output and employment. • When inventories fall and businesses respond with an expansion in output in an effort to restore inventories to their normal levels.

39. Keynesian Equilibrium • Keynesian equilibrium can occur at less than the full employment output level. • When it does, the high rate of unemployment will persist into the future. • Aggregate expenditures (demand) are key to the Keynesian macroeconomic model. • Keynes believed that weak demand was the cause of the Great Depression.

40. < < = > > An Example of Keynesian Equilibrium Planned aggregateexpenditures Plannednet exports Planned consumption Planned investment plusgovernment expenditures Tendencyof output Total Output(real GDP) $ 13.4 $ 13.70 $9.1 $4.4 $0.20 Expand 13.7 13.85 9.3 4.4 0.15 Expand 14.0 14.00 9.5 4.4 0.10 Equilibrium 14.3 14.15 9.7 4.4 Contract 0.05 14.6 14.30 9.9 4.4 Contract 0.00 Recall: Planned Aggregate Expenditures = Planned Consumption plus Planned Investmentplus Planned Government Expenditures plus Planned Net Exports • In the Keynesian system, when total output is less than planned aggregate expenditures, purchases exceed output and inventories decline. Firms expand their output to rebuild their inventories to regular levels. • When output is more than planned aggregate expenditures, output exceeds purchases, and inventories rise. Firms reduce output in order to reduce excessive inventories. • When planned aggregate expenditures equal total output, there is Keynesian macroeconomic equilibrium.

41. Aggregate Expenditures Planned aggregate expenditures(trillions of $) Equilibrium(AE= GDP) 10.0 5.0 45º Output(Real GDP -- trillions of $) 5.0 10.0 • Aggregate expenditures will be equal to total output for all points along the 45° line from the origin. • The 45° line maps out potential equilibrium levels of output for the Keynesian model.

42. Unplanned reductionin inventories AE = C + I + G + NX Keynesian Equilibrium Planned aggregate expenditures(trillions of $) Equilibrium(AE= GDP) 13.85 45º Output(Real GDP -- trillions of $) 13.7 • At output levels below $14.0 trillion (for example 13.7) AE is above the 45° line – expenditures exceed output and thus businesses sell more than they currently produce, diminishing inventories. Businesses expand output.

43. Unplanned increasein inventories Unplanned reductionin inventories AE = C + I + G + NX Keynesian Equilibrium Planned aggregate expenditures(trillions of $) Equilibrium(AE= GDP) 14.15 13.85 45º Output(Real GDP -- trillions of $) 13.7 14.3 • At output levels above $14.0 trillion (for example 14.3) AE is below the 45° line – output exceeds expenditures and thus businesses sell less than they currently produce, increasing inventories. Businesses reduce output.

44. Keynesianequilibrium AE = C + I + G + NX Full Employment(potential GDP) Keynesian Equilibrium Planned aggregate expenditures(trillions of $) Equilibrium(AE= GDP) 14.15 14.00 13.85 45º Output(Real GDP -- trillions of $) 13.7 14.0 14.3 • Keynesian equilibrium exists where planned expenditures just equal actual output. Here that point is at $14.0 trillion. • Full-employment for this example exists at $14.3 trillion. In the Keynesian model, macroeconomic equilibrium does not necessarily coincide with full-employment.

45. AE= GDP AE2 Full Employment(potential GDP) Keynesian Equilibrium Planned aggregate expenditures(trillions of $) AE1 14.3 14.0 45º Output(Real GDP -- trillions of $) 14.0 14.3 • If equilibrium is less than its capacity, only an increase in expenditures (shift AE) can lead to full employment output. • If consumers, investors, governments, or foreigners spend more and thereby shift AE to AE2, output would reach its full employment potential.

46. AS AE3 AE= GDP 14.6 Full Employment(potential GDP) Keynesian Equilibrium Planned aggregate expenditures(trillions of $) AE2 AE1 14.3 14.0 45º Output(Real GDP -- trillions of $) 14.0 14.3 • Once full employment is reached, further increases in AE, such as to AE3, lead only to higher prices – nominal output expands along the black segment of AE (those points beyond the full employment output level at $14.3 trillion) but real output does not.

47. Aggregate Expenditure and AD-AS Models • The AE model implies that increases in demand will expand output until full employment is reached. • Within the AD-AS model, this implies that the SRAS curve is horizontal until full employment is achieved. • Once full employment is reached, the AE model implies that additional demand will lead only to a higher price level. • Within the AD-AS model, this implies that the SRAS curve is vertical at the full employment level of output.

48. Shifts In Demand, Prices, and Output • An important implication of Keynesian analysis within the AD-AS framework: • When substantial idle resources are present, increases in AD will lead primarily to an expansion in output and the impact on the general level of prices will be small. • When an economy is at or near full employment, increases in AD will lead primarily to a higher price level rather than a substantial increase in output.

49. 1. According to the Keynesian view, which of the following is true? a. Businesses will produce only the quantity of goods and services they believe consumers, investors, governments, and foreigners will plan to buy. b. If planned aggregate expenditures are less than full employment output, output will fall short of its potential. c. Equilibrium can only occur at the full employment rate of output. Questions for Thought:

50. Questions for Thought: 2. Within the framework of the Keynesian AE model, if the planned expenditures on goods and services were less than current output, a. business firms would reduce their output and lay off workers in the near future. b. the wage rates of workers would decline and thereby help to direct the economy to full employment. 3. What changes output in the Keynesian AE model?